5) There is no question that passing the TARP was the right thing to do. In some countries, the government has the authority to provide fiscal resources directly to the banking system on a huge scale, but in the United States this requires congressional approval. In other countries, foreign loans can be used to bridge any shortfall in domestic financing for the banking system, but the U.S. is too large to ever contemplate borrowing from the IMF or anyone else.

That’s important to keep in mind. I know some serious people on the left (Dean Baker) and the right (Scott Sumner) who think this analysis is wrong and that the Fed could/should have prevented economic collapse without this intervention. But some conventional wisdom has emerged among activists that only corrupt capture by the banking establishment can explain belief in the necessity of TARP. Simon Johnson is not, I think, corruptly captured by the banking establishment.

Now the key implementation problems:

10) Seen in this context, TARP was badly mismanaged. In its initial implementation, the signals were mixed – particularly as the Bush administration sought to provide support to essentially insolvent banks without taking them over. Standard FDIC-type procedures, which are best practice internationally, were applied to small- and medium-banks, but studiously avoided for large banks. As a result, there was a great deal of confusion in financial markets about what exactly was the Bush/Paulson policy that lay behind various ad hoc deals.

11) The Obama administration, after some initial hesitation, used “stress tests” to signal unconditional support for the largest financial institutions. By determining officially that these firms did not lack capital – on a forward looking basis – the administration effectively communicated that it was pursuing a strategy of “regulatory forbearance” (much as the US did after the Latin American debt crisis of 1982). The existence of TARP, in that context, made the approach credible – but the availability of unconditional loans from the Federal Reserve remains the bedrock of the strategy.

I think point 11 remains unduly appreciated. Note that one reason the Obama administration chose this approach is that the alternatives to regulatory forbearance and recapitalization through profits would involve higher not lower fiscal costs than was involved with the grossly unpopular TARP (whose fiscal costs have actually been extremely low). The alternative to regulatory forbearance would have required the taxpayers to step up with additional capital in a way that would have played in the press as “giving even more money to the big banks.” But failing to pony up the cash ended up being even more favorable to the bankers:

14) Exacerbating this issue, TARP funds supported not only troubled banks, but also the executives who ran those institutions into the ground. The banking system had to be saved, but specific banks could have wound down and leading bankers could and should have lost their jobs. Keeping these people and their management systems in place serious trouble for the future.

15) The implementation of TARP exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.” This lowers their funding costs, probably by around 50 basis points (0.5 percentage points), enabling them to borrow more and to take more risk with higher leverage.

Not only the institutions, but the specific actors managing the institutions have been largely sheltered from downside risk.

As I have said, the Bagehot Rule for dealing with a financial crisis--a century and a half old and still state-of-the-art--is that in a crisis the government should lend freely to institutions in trouble but needs to do so at a penalty rate so that the defalcators don't profit from the systemic risk that they have created. In the case of institutions that are not just illiquid but insolvent, lend freely at a penalty rate means take equity and nationalize.

5) There is no question that passing the TARP was the right thing to do. In some countries, the government has the authority to provide fiscal resources directly to the banking system on a huge scale, but in the United States this requires congressional approval. In other countries, foreign loans can be used to bridge any shortfall in domestic financing for the banking system, but the U.S. is too large to ever contemplate borrowing from the IMF or anyone else.

That’s important to keep in mind. I know some serious people on the left (Dean Baker) and the right (Scott Sumner) who think this analysis is wrong and that the Fed could/should have prevented economic collapse without this intervention. But some conventional wisdom has emerged among activists that only corrupt capture by the banking establishment can explain belief in the necessity of TARP. Simon Johnson is not, I think, corruptly captured by the banking establishment.

Now the key implementation problems:

10) Seen in this context, TARP was badly mismanaged. In its initial implementation, the signals were mixed – particularly as the Bush administration sought to provide support to essentially insolvent banks without taking them over. Standard FDIC-type procedures, which are best practice internationally, were applied to small- and medium-banks, but studiously avoided for large banks. As a result, there was a great deal of confusion in financial markets about what exactly was the Bush/Paulson policy that lay behind various ad hoc deals.

11) The Obama administration, after some initial hesitation, used “stress tests” to signal unconditional support for the largest financial institutions. By determining officially that these firms did not lack capital – on a forward looking basis – the administration effectively communicated that it was pursuing a strategy of “regulatory forbearance” (much as the US did after the Latin American debt crisis of 1982). The existence of TARP, in that context, made the approach credible – but the availability of unconditional loans from the Federal Reserve remains the bedrock of the strategy.

I think point 11 remains unduly appreciated. Note that one reason the Obama administration chose this approach is that the alternatives to regulatory forbearance and recapitalization through profits would involve higher not lower fiscal costs than was involved with the grossly unpopular TARP (whose fiscal costs have actually been extremely low). The alternative to regulatory forbearance would have required the taxpayers to step up with additional capital in a way that would have played in the press as “giving even more money to the big banks.” But failing to pony up the cash ended up being even more favorable to the bankers:

14) Exacerbating this issue, TARP funds supported not only troubled banks, but also the executives who ran those institutions into the ground. The banking system had to be saved, but specific banks could have wound down and leading bankers could and should have lost their jobs. Keeping these people and their management systems in place serious trouble for the future.

15) The implementation of TARP exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.” This lowers their funding costs, probably by around 50 basis points (0.5 percentage points), enabling them to borrow more and to take more risk with higher leverage.

Not only the institutions, but the specific actors managing the institutions have been largely sheltered from downside risk.

As I have said, the Bagehot Rule for dealing with a financial crisis--a century and a half old and still state-of-the-art--is that in a crisis the government should lend freely to institutions in trouble but needs to do so at a penalty rate so that the defalcators don't profit from the systemic risk that they have created. In the case of institutions that are not just illiquid but insolvent, lend freely at a penalty rate means take equity and nationalize.